Is It Time To Let State Governments Declare Bankruptcy?

After approving another multi-billion dollar coronavirus relief bill, Senate Majority Leader Mitch McConnell made big public policy news when he argued in a radio interview that states seeking bailouts to cover the costs of their underwater government employee pensions should instead have the ability to declare bankruptcy to restructure their unsustainable liabilities.

Reuterscovered the Kentucky senator’s proposal:

U.S. Senate Majority Leader Mitch McConnell on Wednesday opened the door to allowing U.S. states to file for bankruptcy to deal with economic losses stemming from the coronavirus outbreak that are punching big holes in their budgets.

Under current law, states are prohibited from filing for bankruptcy, although city and county governments may do so if allowed under their state’s law.

In recent years, the U.S. government has been inching closer toward allowing states the same option, with President Obama signing a 2016 law enabling Puerto Rico to effectively declare bankruptcy and setting a precedent for U.S. territories. Extending the option of bankruptcy to state governments is not that far off.

The issue didn’t arise out of the blue. Senator McConnell’s proposal follows the state of Illinois’ bid to have the U.S. government provide a multi-billion dollar bailout of the state’s mismanaged pension funds for state and local government employees as part of the funds it was seeking from a recent coronavirus epidemic relief package. The editors of the Chicago Tribune have some choice words for the state’s gambit:

It is not surprising an Illinois politician finally put in writing what economists and financial watchdogs have been warning for years: That elected officials who failed to take seriously decades of fiscal warning bells in this state eventually would seek a bailout from the federal government.

What is beyond galling is using the coronavirus as an excuse. But that’s what Illinois Senate President Don Harmon, D-Oak Park, did last week in a letter circulated among Illinois’ congressional delegation and obtained by The New York Times. Harmon requested more than $41.6 billion in bailout aid as part of the next coronavirus relief package, including $10 billion for Illinois pensions, due to economic collapse from the virus.

Even by this state’s low standards, asking federal taxpayers from California to North Carolina, from North Dakota to Texas — farmers, small business owners, teachers, nurses, bus drivers, bartenders — to help dig Illinois out of its pre-coronavirus, self-inflicted, financial hellhole is astonishingly brazen. Every member of Congress should carefully scrutinize pleas from states whose unbalanced budgets, embarrassing credit ratings and vastly underfunded pension systems predated virus outbreak.

Indeed they should. But Illinois is not the only state at risk of fiscal insolvency because of the cost of its overgenerous pension benefits for state government employees. Writing at City Journal, Steven Malanga considers the state of California’s predicament with its public employee pension funds:

With about $350 billion in assets—down from about $400 billion at the market’s height, earlier this year—CalPERS is the nation’s largest public-employee pension fund. It took a battering in the last recession, when its funding shrank from 87 percent of the money needed to meet future obligations in 2007 to just 68 percent a few years later. After an 11-year market expansion, though, CalPERS is barely more than 70 percent funded, as of last June. Taxpayers have paid the price. The state and its local governments funnel $15.6 billion into the fund, up from $6.4 billion in 2007.

CalPERS CEO Marcie Frost assures local officials that the system is prepared to weather this downturn, having reduced its exposure to volatile stocks. Nonetheless, the CalPERS rate of return for the first nine months of the current fiscal year, which ended on March 31, was negative 4 percent, compared with a projected annual gain of 7 percent, which is necessary to keep CalPERS from taking on more debt and forcing even higher payments from local governments. Officials estimated that even if the fund scratches its way back to a zero-percent return for the fiscal year that ends June 30, its funding status would slip to about 66 percent. Under the worst-case scenario—a 10 percent investment loss—the nation’s largest public-employee retirement system would have just 60 percent of the money on hand that it needs to meet future obligations.

Both scenarios would require more money from taxpayers. For public-safety workers who are part of CalPERS, local governments are already paying pension costs equal to 50 percent of every worker’s salary. Over five years, CalPERS says, that amount could increase to nearly 70 percent of salary cost. For every $1 in salary paid to a cop or firefighter, a jurisdiction would need to spend almost 70 cents more just on pension costs. California schools are paying the equivalent of 28 percent of salaries to fund pensions for employees who are part of CalPERS. If assets decline by 10 percent, governments would have to contribute 37 cents for every dollar of salary paid to school employees who are part of CalPERS—a one-third increase in pension costs over four years. No wonder, then, that Frost acknowledges “the affordability of [pension] plans has become ever more difficult” for the 3,000 local-government entities in the state that provide workers with pensions through CalPERS. Last week, school officials around the state asked Governor Gavin Newsom to delay scheduled pension increases.

If the costs of providing such generous pension benefits to government employees who are no longer working sound unsustainable, that’s because they are. And part of that problem is because of investment decisions made by CalPERS’ management, who made an amazingly bad investment decision despite being warned against it just weeks before the markets crashed. Market Crumbs explains:

According to insiders, CalPERS removed one of its two hedges against tail-risk just a few weeks before the coronavirus caused the stock market to plummet.

Although the hedge CalPERS did maintain generated “several hundred million dollars” for the pension, the hedge CalPERS exited would’ve generated more than $1 billion for the fund.

CalPERS Chief Investment Officer Ben Meng said the hedges were terminated because they were costly and other methods were cheaper, more effective and better suited for CalPERS….

Ironically, the outside manager that CalPERS redeemed its funds from was none other than Universa Investments, which is advised by Nassim Taleb, author of the best seller “The Black Swan.” Universa Investments generated a 3,612% return in March and 4,144% return year to date.

The terminated hedge that would’ve generated more than $1 billion for CalPERS returned more than 3,600% in March, validating the warning Junkin gave to CalPERS’ executives and board members.

Instead, CalPERS is hemorrhaging money, which state government officials will almost certainly seek to make up by increasing taxes on California’s already heavily taxed population — unless they can exercise another option to restructure and reduce their costly liabilities.

Another factor to keep in mind is that state government officials have been primarily responsible for the decisions to shut down businesses across their states. This untargeted response to the coronavirus epidemic is what is directly causing the shortfalls in state tax revenue for which they are now seeking relief from the U.S. government.

At a certain point, compelling people with long records of making costly decisions to face up to their poor judgment through bankruptcy proceedings isn’t a bad idea. It is simply what should come after their long, uninterrupted series of bad ideas.

Craig Eyermann is a Research Fellow at the Independent Institute.
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